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The determination of "financial distress" for purposes of business rescue

15 April 2013

Routledge Modise

If a company is to benefit from the protection afforded to it under business rescue it must first be "financially distressed". This is the requirement for both mechanisms allowed by Chapter 6 of the Companies Act 71 of 2008 (the Act) before a company may be placed in business rescue, whether by means of a company resolution (Section 129 of the Act) or by an order of court (Section 131 of the Act).

In terms of Section 128(1)(f) of the Act, a company is "financially distressed" if it appears to be (a) reasonably unlikely that the company will be able to pay all of its debts as they fall due and payable within the immediately ensuing six months (often referred to as commercial insolvency-when a company is able to pay some but not all of its debts) ; or (b) reasonably likely that the company will become insolvent within the immediately ensuing six months (its liabilities exceeds its assets).

Therefore, when the board of directors or an affected person contemplates placing the company in business rescue it should first ask, "Is the company financially distressed?"

The determination of whether a company is financially distressed is not the only test the company has to pass before it may qualify for business rescue. The other test is whether the rescue of the business is economically viable so as to avoid the doom of impending liquidation.

It is often the case that companies fail the second test, and go "bust" because the board of directors or affected persons have failed to act earlier in implementing rescue measures.

Business rescue must be conducted with the maximum possible expedition. In most cases failure to expeditiously implement rescue measures when a company is in financial distress will lessen or negate the prospect of effective rescue (Koen & Another v Wedgewood Village Golf & Country Estate (Pty) Limited & others [2012] JOL 29024 (WCC)).

As a general rule the prospects of a financially distressed company being successfully rescued diminish over time. Thus it is important for directors to understand and recognise the indicators of financial distress as early as possible.

There are many financial indicators that must be considered when deciding whether a company is financially distressed. According to business analyst, Sanjay Galal (Galal) of Impumelelo Financial Advisory Solutions, these include the following (this list is not exhaustive but provides a functional guideline):

Continued Losses: Simply put a company's income and expenditure statement for the past few years when examined could reveal continuing increase in losses over these years.

Declining turnover: A decrease in turnover normally causes an increase in inventory levels. This is gauged from the company's statement of financial position.

Adverse Working Capital Ratios: These primarily reflect the liquidity of the company. This is when the company's statement of financial position current ratios (current assets versus current liabilities) or quick ratios (current assets (excluding inventory) versus current liabilities) for recent periods show a steady decline in working capital. An example of this would be if current ratios for 2010 were at 1.39%, but for 2012 it was at 0.39, it means that for every R100 loss the company would have only achieved a R39 gain in 2012. A quick ratio, often referred to as the acid test, may reveal the same scenario. The quick ratio differs from the current ratio in that inventory is excluded from the quick ratio. Both these ratios like the example, show that current liabilities are greater than current assets. This is a sign of financial distress.

Adverse Solvency Ratios: This is one of many ratios used to measure a company's ability to meet long-term obligations. The solvency ratio measures the size of a company's after-tax income, excluding non-cash depreciation expenses, as compared to the firm's total debt obligations. It provides a measurement of how likely a company will be to continue meeting its debt obligations. These solvency ratios, which appear in a company's statement of financial position, may reveal a decline in debt to equity ratios and an increase in total liabilities to total assets ratios. For example, a Gearing ratio (Debt/Equity) could reveal the following decline over time, 2010(1571%), 2011(-192%), 2012 (-89%) and the Debt ratio (Total Liabilities/Total Assets) could indicate the following increase over time 2010(96%), 2011(149%), 2012(278%). Generally, the lower a company's solvency ratio, the greater the probability that the company will default on its debt obligations.

Adverse Profitability Ratios: These are a class of financial metrics that are used to assess a business's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time. Examples of profitability ratios are profit margin, return on assets and return on equity. It is important to note that a little bit of background knowledge is necessary in order to make relevant comparisons when analysing these ratios.

For instances, some industries experience seasonality in their operations. The retail industry, for example, typically experiences higher revenues and earnings for the Christmas season. Therefore, it would not be too useful to compare a retailer's fourth-quarter profit margin with its first-quarter profit margin. On the other hand, comparing a retailer's fourth-quarter profit margin with the profit margin from the same period a year before would be far more informative. An adverse profit ratio will show as a negative percentage which has declined over a period of time when comparing net profit to revenue.

Negative cash flows from operating activities: A cash flow statement is split between operating, investing and financing activities. A definite financial distress indicator is when a company experiences a net cash outflow from its operating activities when considering historical and projected figures. For example in 2011 the net cash outflow on operations was –R600 000 and in 2012 it increased to –R1 500 000.

Increased long term financing for short term needs: Generally, long term loans and financing should be used in order to finance noncurrent or long term assets and not for short terms needs. If this is being done, this is a further financial distress indicator.

Inability to pay creditors on due dates: This analysis requires a determination of the following:

  • The company's cash conversion cycle must be looked at to determine the efficiency of the payment periods of trade creditors. Settlement dates of creditors invoices should be compared to actual payment dates and the creditors statement;
  • A computation of trade creditors over cost of sales for a 365 day period, compared to historic results can substantiate this analysis;
  • A further distress indicator is reluctance by suppliers and other creditors in affording credit terms and possible reasons therefor.

Actual versus budgeted performance: The variances between actual versus budgeted and actual versus projected results need to be computed and analysed. If the results reveal continuous underperformance of actuals to budgets these are tell-tale signs of distress.

Default in long term debt repayments:

  • A detailed review of long term borrowings and lending arrangements is necessary to evaluate whether there is difficulty in meeting interest and capital repayments to creditors;
  • A computation of the interest coverage ratio is also required. This ratio is used to determine how easily a company can pay interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes of one period by the company's interest expenses in the same period. The lower the ratio, the more the company is burdened by debt expenses;
  • If the company places excessive reliance on short term borrowings to finance long term assets this also provides another negative indicator.

Adverse credit ratings: The company's credit profile rating needs to be periodically examined to ascertain whether ratings decline.

Risk of market exposure: The question to be asked here is whether the company has become susceptible to undue and unmanaged exposure to currency, interest and commodity fluctuations within the market.

Downward trends in entity's share price (only applicable to listed companies): This is done by computing the company's price earnings ratio and comparing it to that of competitors in the industry to determine if it is within acceptable thresholds.

The presence of one or more of these financial indicators, according to Galal, does not automatically mean that a company is in financial distress. These financial indicators should be viewed collectively and with due regard to solvency factors as well as other indicators that are derived from the company's operational and managerial activities as well those from regulatory, legal or external indicators, if these exist.

In all, a thorough analysis of these indicators ought to be adopted by any board of directors or affected person in determining whether a company is in financial distress for the purposes of business rescue. This must however be done well before the point beyond return. Often a board of directors and even a major creditor can foresee these financial indicators a year or more before total collapse.

The next test after determining that the company is financially distressed, is to determine if there is a reasonable prospect of rescuing the financially distressed company. That is a topic for another article.

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